401(k): Pass or Fail?

Despite only being 35 years old, it might be time to retire the 401(k).

The 401(k) started out as a tax loop hole to supplement workers' savings and has grown to become Americans’ main retirement savings tool. But many baby boomers are finding their retirement in tatters and aren’t able to leave the workforce due to grossly inadequate savings.

“These accounts were never meant to serve as the primary retirement savings tool,” says Robert Hiltonsmith, policy analyst Demos. “They were created as a vehicle for high earners to supplement their other retirement benefits. But through lobbying, shifts in the labor market and job trends they became the primary savings vehicle without a national conversation.”

According to the Employee Benefit Research Institute, only 22% of workers 55 or older have $250,000 saved for retirement. What’s more, 60% of that same age group has less than $100,000 socked away. Clearly not enough to retire.

Here’s the problem: many of us don’t have the skills and become too emotionally attached when investing.

“Linking investing and retirement doesn’t work and we are seeing the proof of that right now,” says Teresa Ghilarducci, an economist at the New School, who studies retirement.

No one claims retirement planning is easy, and studies show that over the last few years, Americans are saving more specifically for their golden years, but it hasn’t been enough.

Ghilarducci explains that retirees need to aim for nearly 20 times their yearly income: someone taking home a $100,000 a year, will need about $2 million to retire on top of Social Security.

“We are finding 401(k)s are not an adequate way for people to save for retirement because most working families find they don’t have the resources to funnel money into these accounts, “ says Diane Oakley, executive director of the National Institute on Retirement. “With wages remaining stagnate they’re having a hard time just making ends meet.”

How We Got Here

401(k) plans were originally knows as salary-reduction plans and were created as an executive perk for high-paid workers. “This idea was invented for a specific group, but was sold by consultants who helped package the idea for a broad set of companies. But it wasn’t supposed to become the main tool,” says Ghilarducci.

When employers started offering 401(k)s more than 30 years ago, the now-baby boomers started putting money into the tax-deferred accounts when they became available and watched them grow during the 1982 bull market. This rally boosted consumers’ confidence, but the rally and their savings accumulation came to a screeching halt in 2000 when the tech bubble burst. This cycle repeated when Wall Street rallied from 2003 to 2007 until the 2008 financial crisis hit. The average 401(k) balance slipped around 31% during the Great Recession, according to Fidelity.

Now, many boomers can’t afford to leave the work force, which is bad news for the Millennials just entering the labor market.

“That’s the important thing about a retirement plan--it is designed to encourage people to leave the workforce when it’s time for them to leave, but now people are working longer, which disrupts the labor market by not opening up positions to be filled with the younger generations,” says Oakley.

Pass or Fail?

Oakley says in order for the 401(k) to fulfill people’s retirement needs they have to start investing in one early and not take out the funds before their retirement—both aren’t happening.

“One out of 4 households are borrowing money from their 401(k) and they are doing it later in life…in their 40s. It’s really hard to make that up. Compound interest works really, really well when you start saving young.”

Ghilarducci points to three main components that need to be present in a successful savings vehicle: proper investing, sufficient accumulation for individuals and enough payout in retirement. As of right now, the 401(k) isn’t hitting the mark.

How to Fix It

Young workers are growing increasingly worried about their ability to fund their golden years. “Young people today don’t want mom and dad’s 401 (k) plan, they want grandpa’s pension,” says Oakley.

Ghilarducci proposes a “guaranteed retirement account” on top of Social Security that would have all workers and employees contribute a set percentage. The accounts would be required, managed by a professional and have a guaranteed rate of return and pay out annuities.

She also says Congress needs to take a closer look at tax breaks. “The tax break on 401(k)s are the largest write offs… 80% of the 401(k) deductions goes to the top 20% of earners, the people that don’t really need the help” she says.

Seven states are considering a non-for-profit, low-fee guaranteed plan to its residents, she says.

To improve the current 401(k) system, Hiltonsmith says the risk needs to be spread out better. “Right now the risk is totally on the back of savers -- businesses, employers, and managers don’t have any risk.” He says a state-level guaranteed retirement account would do the trick to provide lifetime income for people that shields from market risk.

Washington has also stepped into the conversation with proposals on how to fix the retirement gap. The Obama Administration has proposed allowing workers to use 401(k) funds to buy annuities. Senator Tom Harkin, (D-Iowa), has also talked about creating a national private pension plan.

Matt Fellowes, founder and CEO of HelloWallet, says 401(k) plans are “the best option available” but that the automation policy needs improvement.

“We all thought that allowing employers to automatically enroll workers into a retirement savings program would save the world. Unfortunately, the shortcoming of that automation is that it's a very blunt instrument and a lot of people instead needed to be defaulted into basic savings programs instead of that 401(k).”